Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 9 MIN READ

The PTET map in May 2021: eleven states, one IRS blessing, and California next

Three years after Connecticut went first, the pass-through entity tax has gone from contrarian workaround to default planning tool

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What the states actually enacted
  2. Why November 9, 2020 changed everything
  3. The math, run at the margin
  4. The wrinkles practitioners are watching
  5. California, and what comes next
  6. Sources

leven states have now enacted a pass-through entity tax, and the IRS has blessed the structure federally. What was a contrarian Connecticut experiment in 2018 is, in May 2021, the default planning move for any profitable partnership or S-corp whose owners live in a high-tax state.

The acceleration is the story. Through 2019 the count was four states. By year-end 2020 it was seven. In the first four months of 2021 alone, Alabama, Arkansas, Georgia, and Idaho have signed PTET bills into law, and California's AB 150 is sitting in the Senate. Behind the jump is a single IRS notice that arrived on November 9, 2020, and removed the only credible reason a practitioner might have told a client to wait.

What the states actually enacted

The legislative architecture varies, but every PTET does the same three things. It imposes a tax at the entity level on the pass-through's income, usually at or near the state's top individual rate. It gives the entity a deduction for that tax on its federal return, where the $10,000 SALT cap does not apply because the cap lives on Schedule A and entity-level state taxes live on the federal partnership or S-corp return. And it gives the owners a credit on their personal state return equal to the tax the entity paid, so the owners are not taxed twice at the state level. The net effect is that state income tax on pass-through income gets converted from a capped personal itemized deduction into an uncapped business expense.

For background on why this workaround exists at all and what the early-2018 experiments looked like, see our November 2018 piece on the SALT cap and the first PTET experiments, and our one-year look at Connecticut's PTET from August 2019.

Connecticut, which went first under P.A. 18-49 in May 2018, remains the only mandatory PTET on the map; every state that has followed has made the election annual and at the entity's option. Wisconsin's 2017 Act 368, signed in December 2018 and effective for tax years beginning on or after January 1, 2018 for S-corps and January 1, 2019 for partnerships, was the first elective PTET. Oklahoma's HB 2665 (2019) and Louisiana's Act 442 of the 2019 Regular Session followed, both elective.

Rhode Island tucked its elective PTET into the FY 2020 budget (H 5151A, signed July 5, 2019), at a 5.99% entity rate tracking the top individual bracket. New Jersey enacted the Business Alternative Income Tax under P.L. 2019, c. 320 (signed January 13, 2020), with a graduated rate topping out at 10.9% on entity income above $5 million, and made it effective for tax years beginning on or after January 1, 2020. Maryland's SB 523 (2020), signed May 8, 2020 over the Governor's veto override history, allowed an elective entity-level tax for tax year 2020 and forward.

That takes the count to seven by the end of 2020. The 2021 additions come in quickly. Alabama's Act 2021-1, signed February 12, 2021, authorizes an electing PTE to pay at the top 5% individual rate. Georgia's HB 149, signed May 4, 2021 (today, and the hook for this article), provides an entity-level election at 5.75%. Arkansas enacted SB 362 on April 29, 2021, authorizing an elective pass-through entity tax at the top 5.9% rate. Idaho's HB 317, signed April 15, 2021, created an affected business entity election at 6.925%. Eleven states in total, with California's AB 150 pending and expected to move this summer.

Why November 9, 2020 changed everything

The structural question hanging over every pre-2021 PTET was whether the IRS would honor the entity-level deduction or recharacterize it as a disguised payment of the owners' personal state tax. Treasury's August 2018 proposed regulations on charitable-contribution workarounds had left the PTET question deliberately open, and practitioners had been advising clients that the deduction probably worked but carried a non-trivial audit risk.

IRS Notice 2020-75, released November 9, 2020 and published as 2020-49 I.R.B. 1453, ended that uncertainty. The Notice announced that Treasury and the IRS intend to issue proposed regulations clarifying that specified income tax payments made by a partnership or S-corp to a state, political subdivision, or the District of Columbia in satisfaction of the entity's own income tax liability are deductible in computing the entity's non-separately stated taxable income for the year of payment. The Notice applies to payments made on or after November 9, 2020, and to payments made in tax years ending before that date under statutes enacted before November 9, 2020.

The important operational point buried in the second paragraph: the deduction is not a separately stated item. It flows through to the owners already embedded in the ordinary business income on their K-1s, which means it reduces their federal adjusted gross income directly, not as an itemized deduction subject to the SALT cap. That is exactly the result the statutes were drafted to produce, and the IRS confirmed it.

The Notice is not a regulation; Treasury still has to issue the proposed rule it described. But for planning purposes, the risk calculus has flipped. Before November 9, the advice was "this probably works, price the uncertainty." After November 9, the advice is "elect unless you have a state-specific reason not to."

The math, run at the margin

The planning math is straightforward once you see it. Take a New Jersey S-corp owner with $1 million of ordinary pass-through income, no other state taxable income complications, and who already hits the $10,000 SALT cap from property taxes alone. At New Jersey's BAIT top rate of 10.9% on income over $5 million and 9.12% on the portion between $1 million and $5 million, the entity-level tax on $1 million of income runs at 6.52% (using the BAIT graduated schedule; the first $250,000 is at 5.675%, the next $750,000 at 6.52%). Call the BAIT bill roughly $65,000 on $1 million.

Without PTET, the owner pays $91,200 of New Jersey personal income tax at the 9.12% marginal rate, gets no federal deduction for it beyond the $10,000 SALT cap (already consumed by property tax), and has $1,000,000 of federal taxable pass-through income.

With BAIT, the entity pays roughly $65,000 of New Jersey tax, deducting it federally as a business expense. The owner's K-1 now shows $935,000 of pass-through income instead of $1,000,000. On the owner's New Jersey return, the BAIT credit of $65,000 offsets the owner's $91,200 personal liability, leaving $26,200 still owed personally at the state level. State-level tax is roughly the same either way, give or take a few basis points from rate differentials between the entity and personal schedules. What moves is the federal base: the owner has shifted $65,000 of deduction from the capped Schedule A line to the uncapped business line. At a 37% federal marginal rate, that is roughly $24,000 of federal tax savings on a $1 million income year. The savings scale linearly.

The math is most compelling in states where the top individual rate is high and the owner is already over the SALT cap. California at 13.3%, New York at 10.9% on incomes above $25 million under the April 2021 budget, New Jersey at 10.75% on incomes over $5 million, and Oregon at 9.9% produce the largest per-dollar savings. Connecticut and Maryland, where the rates are mid-single-digit, produce smaller savings but still positive ones for owners above the cap.

The wrinkles practitioners are watching

Three operational issues are not fully resolved as of May 2021, and each of them is worth flagging to any client considering an election.

The first is non-resident owner credits. If a Connecticut S-corp has a California-resident shareholder, the Connecticut PTET generates Connecticut tax paid by the entity. Whether California will give the shareholder a full credit for that Connecticut tax on her California return (under R&TC § 18001 or equivalent other-state-credit provisions) depends on whether California treats the entity-level tax as a tax imposed on the shareholder. California has taken the position in draft guidance that it will allow the credit, but several states have not issued clear guidance, and Massachusetts, which has no PTET of its own, has been notably silent on whether it will credit other states' entity-level taxes.

The second is the treatment of the federal deduction for tiered partnerships. If an upper-tier partnership receives an allocation of ordinary income from a lower-tier partnership that has paid a PTET, does the deduction flow through intact, or does it fail the "specified income tax payment" test at the upper tier? Notice 2020-75 does not squarely address tiered structures, and the proposed regulations when they issue will have to.

The third is the interaction with the qualified business income deduction under IRC § 199A. Because the PTET reduces the pass-through income that flows to the K-1, it also reduces the QBI base on which the 20% deduction is computed. For owners who were already limited by the W-2 wage or UBIA tests, this is a wash. For owners whose 199A deduction is driven purely by QBI, the PTET election shrinks the deduction modestly. The federal savings from the uncapped SALT deduction almost always exceed the 199A shrinkage, but the calculation needs to be run, not assumed.

California, and what comes next

California is the prize and the awkward case. AB 150, as introduced by Assemblymember Burke in January 2021, would create an elective 9.3% pass-through entity tax beginning in 2021 and sunsetting with the TCJA SALT cap itself at the end of 2025. The bill cleared the Assembly in April and is in Senate committee. If it passes in something close to its current form, California will immediately become the largest PTET state by both taxpayer count and dollars, and the workaround will have moved from regional curiosity to a standard feature of pass-through tax planning nationwide.

The states still on the sidelines in May 2021, in descending order of how strange their absence looks: New York (which has its own $10,000 cap pain and a legislature that has been talking about a PTET for two years), Massachusetts, Virginia, North Carolina, Minnesota, Colorado, and a long tail of lower-tax states for whom the arithmetic matters less. New York budget negotiations in April 2021 explicitly contemplated a PTET; whether it lands in a budget extender or a standalone bill is the remaining question of the year.

The structure has moved from workaround to infrastructure in under three years, which is fast for state tax law. The remaining work is cleanup: the non-resident credit question, the tiered-partnership mechanics, and whatever Treasury puts in the proposed regulations promised by Notice 2020-75. None of those are deal-breakers. They are the kind of problems practitioners solve quietly, client by client, while the underlying structure quietly becomes universal.

Sources

Keep reading

More from the journal.